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Issue 83 Articles, Issue 83: Sep 2018

Securities Class Actions

BY Hearsay

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^[1] and the Vexing Question of Causation

In 2016 Justice Beach of the Federal Court made the following observation:

Litigation funding has produced the following outcomes. First, there has been a proliferation of closed ^{^[2]} proceedings. Second, the subject matter of class actions has shifted from product liability claims to securities actions (e.g. shareholder class actions). One reason is due to the economics. In terms of the aggregate claimed, this is likely to be larger for shareholder class actions. Second, it may be thought that it is easier to establish liability for material non-disclosure claims. After all, when negative news is published to the market by a listed company and its share price plummets, plaintiffs’ lawyers’ intuition is to question whether there has been timely disclosure and to assume that there is a ready-made prima facie case of breach of the applicable normative standard. A third factor is that there is perceived to be a very high settlement rate (indeed no shareholder class action as such has proceeded to judgment). This is attractive to plaintiffs’ lawyers and external funders. The high settlement rate has been partly attributed to uncertainty over the viability of market-based causation. Whether such a settlement rate is maintained remains to be seen.^{^[3]}

His Honour noted that at the time of his paper the issue of causation remained unresolved. It still does.

The question of causation may be addressed, as noted by Beach J, ^{^[4]} in one of three ways.

By adopting the ‘fraud on the market’ doctrine of the US.
By requiring proof of actual reliance on the impugned statements or conduct.
By adopting an indirect or market-based causation.

A New South Wales Supreme Court decision has come down on the side of indirect or market causation, holding that actual reliance is not required (although not a representative proceeding, the reasoning is apposite to such actions.).^{^[5]} It is understood that this decision has not been appealed. This case is discussed in detail below.

The doctrine of fraud on the market

The doctrine of Fraud on the Market is a creation of United States jurisprudence. It owes its existence to securities fraud class actions. The doctrine received the approval of the United States Supreme Court in 1988 in Basic Inc v Levinson (‘Basic’). ^{^[6]}That approval was not unanimous, however, as two of the participating Justices dissented.^{^[7]}

The facts of Basic are:

Basic was a publicly traded company primarily engaged in the business of manufacturing chemical refractories for the steel industry.

Beginning in September 1976 representatives of another company, Combustion Engineering Inc (Combustion), had meetings and telephone discussions with officers of Basic concerning the possibility of a merger.

On 21 October 1977 Basic published a news item stating that it knew of no reason for heavy trading in its stock, and stating that no negotiations were under way with any company for a merger.

On 25 September 1978, in response to an inquiry from the New York Stock Exchange, it said that it was unaware of any present or pending company development that would have resulted in the recent price fluctuations and heavy trading in the company’s stock.

On 6 November 1978 Basic issued a nine months report to stockholders where it stated that it was unaware of any present or pending company development that would have resulted in the price fluctuations and heavy trading in the company’s stock in recent months.

On 18 December 1978 Basic asked the New York Stock Exchange to suspend trading in its shares and issued a release stating that it had been approached by another company concerning a merger.

On 19 December 1978 the board of Basic endorsed Combustion’s offer.

On 20 December 1978 Basic publicly announced its approval of Combustion’s tender offer for all outstanding shares.

The respondents to the appeal were former Basic shareholders who sold their stock after Basic’s statement on 21 October 1977 and before the suspension of trading on 18 December 1978. They brought a class action against Basic and its directors alleging that they had issued three false or misleading statements in breach of Â§ 10(b) of the Securities Exchange Act of 1934 ^{^[8]} (SEC Act) and Rule 10b-5 ^{^[9]} promulgated under that Act by the Securities Exchange Commission.

Relevantly, section 10b ^{^[10]} of the SEC Act provides as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means of instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchangeâ

…

b. To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission ^{^[11]} may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Rule 10b-5 relevantly is as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

a. To employ any device, scheme or artifice to defraud,

b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading or,

c. To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The respondents alleged that they were injured by selling Basic shares at an artificially depressed price in a market affected by the misleading statements of Basic.

The District Court for the Northern District of Ohio accepted a presumption of reliance on the alleged misleading statements and considered that common questions of fact predominated over particular questions pertaining to individuals and so certified the case as a class action. ^{^[12]}

Under the American Rules the Court must ‘[ a]t an early practicable time after a person sues or is sued as a class representative, … determine by order whether to certify an action as a class action.’ ^{^[13]}

Whilst the District Court certified the action as a class action, it considered that Basic had made no materially misleading statements because there were no ongoing negotiations at the time of the first statement, and there was no certainty that the negotiations that were taking place at the time of the other statements would result in an agreement in principle. Accordingly, it granted summary judgment for Basic. ^{^[14]}

The United States Court of Appeals for the Sixth Circuit affirmed the class certification but reversed the District Court’s summary judgment. The Supreme Court majority noted the Appeals Court did so because it considered Basic’s statements that no negotiations were taking place, and that it knew of no corporate developments to account for the heavy trading activity, to be misleading.^{^[15]} The Supreme Court majority also noted that the Court of Appeal rejected the argument that preliminary merger discussions are immaterial as a matter of law and held that ‘ “ once a statement is made denying the existence of any discussions, even discussions that might not have been material in absence of the denial, are material because they make the statements made untrue.’ ” ^{^[16]} The United States Supreme Court accepted that for statements to be material for the purposes of the SEC Act and the regulations made under it, there must be a substantial likelihood that disclosure of the omitted fact would be considered by a reasonable investor to ‘have significantly altered the “total mix” of information made available.’ ^{^[17]} ‘Materiality’, therefor, depends ‘on the significance the reasonable investor would place on the withheld or misrepresented information.’ ^{^[18]} Thus, whether merger discussions are material depends on the particular facts of the case. ^{^[19]}

The United States Supreme Court majority said:

The courts below accepted a presumption, created by the fraud-on-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of [Basic’s] material misrepresentations the price had been fraudulently depressed. Requiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, … or if the misrepresentation had not been made, … would place an unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an impersonal market. ^{^[20]}

The Supreme Court majority held:

The fraud on the market theory is based on the hypothesis that the price of a company’s shares in an ‘open and developed securities market’ is determined by ‘the available material information regarding the company and its business.’ ^{^[21]}

Reliance is an element of the cause of action and provides the necessary causal connection between the misrepresentation and the injury. ^{^[22]}

Misleading statements will defraud purchasers of shares even if they do not directly rely on them. ^{^[23]}

Indirect reliance ‘may be adequately established … by proof of materiality coupled with the common sense that a stock purchaser does not ordinarily seek to purchase a loss.’ ^{^[24]}

Thus, the fraud on the market theory is predicated on the assumption that an investor buys or sells shares at the price set by the market in reliance on the integrity of that price. That price reflects the information publicly available regarding the affairs and business of the company, including misrepresentations about such matters. The investor, therefor, is presumed to have also relied upon any misrepresentations, and these misrepresentations have in fact destroyed the integrity of the price.

The presumption of reliance may be rebutted. This may be done by:

proving that the impugned statements were not ‘material’; or
proving that the impugned statements did not adversely affect the share price; or
proving an investor traded or would have traded knowing the statements were false. ^{^[25]}

The dissenting Justices opined that the case law hitherto developed respecting actions based on the sections of the SEC Act and the Regulations under consideration had been based on ‘familiar doctrines of fraud and deceit’. ^{^[26]} It was said by the dissentients that:

[e[ven if [we] agreed with the Court that ‘modern securities markets … involving millions of shares changing hands daily require that the ‘understanding of Rule 10b-5’s reliance requirement’ be changed,… [we] prefer that such changes come from Congress in amending Â§ 10(b). The Congress, with its superior resources and expertise, is far better equipped than the federal courts for the task of determining how modern economic theory and global financial markets require that established legal notions of fraud be modified. In choosing to make these decisions itself, the Court, [we] fear, embarks on a course that it does not genuinely understand, giving rise to consequences it cannot foresee. For while the economists’ theories which underpin the fraud-on-the-market presumption may have the appeal of mathematical exactitude and scientific certainty, they areâin the endânothing more than theories which may or may not prove accurate upon further consideration. Even the most earnest advocates of economic analysis of the law recognize this. … Thus, while the majority states that, for purposes of reaching its result it need only make modest assumptions about the way in which ‘market professionals generally’ do their jobs, and how the conduct of market professionals affects stock prices, …, [we] doubt that we are in much of a position to assess which theories aptly describe the functioning of the securities industry.^{^[27]}

The dissenting Justices further considered that there were two further reasons why the theory should be rejected. Firstly, Congress in considering another provision of the SEC Act dealing with civil liability for misleading statements concerning securities, ^{^[28]} had rejected the notion that a plaintiff could sue under the section based solely on the fact that the securities bought or sold had been affected by a misrepresentation. The majority decision, they thought, was ‘closely akin’ to this rejected basis for establishing liability for securities fraud. ^{^[29]} Secondly, congressional policy favoured the view that securities laws display a strong preference ‘for widespread public disclosure and distribution to investors of material information concerning securities.’ ^{^[30]} The fraud on the market theory subverts this policy, it was said, because it allows ‘monetary recovery to those who refuse to look out for themselves,’ ^{^[31]} and if ‘a plaintiff may recover in some circumstances even though he, she or it did not read and rely on the defendants’ public disclosures, then no one need pay attention to those disclosures and the method employed by Congress to achieve the objective of the 1934 Act is defeated.’ ^{^[32]}

The United States Supreme Court has recently reconsidered the doctrine in Halliburton Co v Erica P John Fund (‘Halliburton’) . ^{^[33]} The Court affirmed acceptance of it, but again, not unanimously.^{^[34]}

The facts of the case were;

Between 3 June 1999 and 7 December 2001 Halliburton made a series of false statements regarding its potential liability in asbestos litigation; its expected revenue from certain construction projects; and the anticipated benefits from a prospective merger,
These statements were alleged to have been made with the intention of inflating the share price.
Halliburton later made a number of statements correcting these mis-statements.
The corrective statements allegedly caused the share price to fall.
The respondent sought to certify the action as a class action comprising all investors who purchased shares during the class period, being between 3 June 1999 and 7 December 2001.

The questions presented to the Supreme Court were whether ‘ [the Court] should overrule or modify Basic’s presumption of reliÂance and, if not, whether defendants should nonetheless be afforded an opportunity in securities class action cases to rebut the presumption at the class certification stage, by showing a lack of price impact.’ ^{^[35]} (‘Price impact’ is the affect that the impugned statements have on the share price.)

Halliburton argued that securities fraud plaintiffs should have to prove direct reliance, that is, they actually relied on the misrepresentation when deciding to buy or sell shares. It advanced two principal propositions in support of this position. Firstly, it was said that the Basic presumption flew in the face of ‘congressional intent.’ Secondly, it was suggested that the fraud on the market theory was discredited by developments in economic theory.

The plurality said the ‘congressional intent’ argument had been run in Basic and the ‘majority did not find the argument persuasive then, and Halliburton has given us no new reason to endorse it now.’ ^{^[36]}

Halliburton also submitted that the fraud on the market doctrine rested on two propositions that could no longer be considered sound, namely, the efficient capital markets hypothesis, and the assumption that investors invest in reliance on the integrity of the market.

The efficient capital markets hypothesis, being the foundation of the doctrine, assumes that the market price of shares traded on well developed markets, reflects all publicly available information, including any misrepresentations. Halliburton cited studies said to show that public information was often not immediately incorporated into market prices. ^{^[37]} Of this the majority said:

Halliburton does not, of course, maintain that capital markets are always inefficient. Rather, in its view, Basic’s fundamental error was to ignore the fact that ’efficiency is not a binary, yes or no question’ . … The markets for some securities are more efficient than the markets for others, and even a single market can process different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood. … Yet Basic, Halliburton asserts, glossed over these nuances, assuming a false dichotomy that renders the presumption of reliance both under inclusive and over inÂclusive: A misrepresentation can distort a stock’s market price even in a generally inefficient market, and a misrepÂresentation can leave a stock’s market price unaffected even in a generally efficient one. ^{^[38]}

…

To recognize the preÂsumption of reliance, the [Basic] Court explained, was not ‘conÂclusively to adopt any particular theory of how quickly and completely publicly available information is reflected in market price’. … The Court instead based the presumption on the fairly modest premise that ‘marÂket professionals generally consider most publicly anÂnounced material statements about companies, thereby affecting stock market prices’. … Basic’s presumption of reliance thus does not rest on a ‘binary’ view of market efficiency. Indeed, in making the preÂsumption rebuttable, Basic recognized that market effiÂciency is a matter of degree and accordingly made it a matter of proof. The academic debates discussed by Halliburton have not refuted the modest premise underlying the presumption of reliance. Even the foremost critics of the efficient-capitalÂ markets hypothesis acknowledge that public information generally affects stock price. ^{^[39]}

The Court held that Halliburton had ‘not identified the kind of fundamental shift in economic theory that could justify overruling a precedent on the ground that it misunderstood, or has since been overtaken by economic realities.’ ^{^[40]}

The majority then turned to Halliburton’s argument that it was wrong to believe that investors relied on the integrity of the market. Here Halliburton suggested that it could identify investors who believed that some shares are either undervalued or overvalued, and traded on that basis hoping to beat the market (e.g. day traders, volatility arbitragers and value investors). Accordingly, if there were some investors who were indifferent to price the courts should not presume that investors rely on the integrity of those prices.

The majority rejected this argument by saying that Basic did not deny the existence of such investors, and that it was ‘ reasonable to presume that most investorsâknowing that they have little hope of outperforming the market in the long run based solely on their analysis of publicly availaÂble informationâwill rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information.’ ^{^[41]} Moreover, even the value investor, they suggested, relied, implicitly at least, on the fact that a share price will eventually reflect all material information because ‘how else could the market correction on which [the investor’s] profit depends occur.’ ^{^[42]}

Halliburton further suggested that that, by facilitating class actions, Basic,

allowed plaintiffs to extort large settlements from defendants for meritless claims;
punished innocent shareholders who finish up paying any settlements or judgments;
imposed excessive costs on business; and
resulted in a disproportionately large share of judicial resources being consumed.

The majority considered that these concerns were more appropriately to be addressed by Congress which had in fact done so, to some extent at least, in two pieces of legislation.âthe Private Securities Litigation Reform Act of 1995 ^{^[43]} and the Litigation Uniform Standards Act of 1998. ^{^[44]}

The majority noted that ‘[b]efore overturning a long- settled precedent … [the court] require[s] “special justification”, not just an argument that the precedent was wrongly decided,’ ^{^[45]} Halliburton, they held, failed ‘to make that showing.’ ^{^[46]}

The dissenting Justices noted that the right of private action under Rule 10bâ5 was one implied by judicial fiat and was not one expressly accorded by Congress. The Court had, they said, now ended that practice and could not now create a cause of action absent statutory authorisation. â the opinion of Thomas J, concurred in by Scalia and Alito JJ.^{^[47]} He said:

Without a statute to interpret for guidance … the Court began instead with a particular policy ‘problem’: for investors in impersonal markets, the traditional reliance requirement was hard to prove and impossible to prove as common among plaintiffs bringing 10b—5 class-action suits. … . With the task thus framed as ‘resol[ving]’ that “‘problem’” rather than interpreting statutory text, … , the Court turned to nascent economic theory and naked intuitions about investment behaviour in its efforts to fashion a new, easier way to meet the reliance requirement. The result was an evidentiary presumption, based on a’fraud on the market’ theory, that paved the way for class actions under Rule 10b—5. ^{^[48]}

As a consequence, ‘[l]ogic, economic realities and … subsequent jurisprudence have underlined the foundation of the Basic presumption, and stare decisis cannot prop up the facade that remains.’ ^{^[49]}

Reliance, in the traditional sense, means proving that the impugned statement actually induced an investor to buy or sell the shares because the investor in fact relied upon the statement. The reality is, however, that an investor buying on a stock exchange will often not be aware of anything said or done by a company, and cannot show the purchase or sale of shares was done in reliance on any particular statement or conduct. Thus, in the context of class actions for securities fraud, it would be impossible for an investor to prove that common questions predominated over individual ones making class certification inappropriate. It was, said Thomas J, to meet this problem that Basic held that mis-statements had been incorporated into the market price of the shares; and that shares had been brought or sold in reliance on the integrity of the market price. ^{^[50]} His Honour considered that the Basic assumptions were wrong because:

The presumption of reliance was based on ‘a questionable understanding of disputed economic theory and flawed intuitions about investor behavior.’ ^{^[51]}
The rebuttable presumption was at odds with the Court’s later opinions which require plaintiffs seeking class certification to ‘affirmatively demonstrate’ certification requirements such as the predominance of common questions. ^{^[52]}
The presumption that investors rely on the integrity of the market price means that in practice the presumption is ‘virtually irrebuttable’ such that ‘the ‘essential’ reliance element effectively exists in name only. ^{^[53]}

In reality said Thomas J:

both of the Court’s key assumptions are highly contestable and do not provide the necessary support for Basic’s presumption of reliance. The first assumptionâthat public statements are ‘reflected’ in the market priceâwas grounded in an economic theory that has garnered substantial criticism since Basic. The second assumptionâthat investors categorically rely on the integrity of the market priceâis simply wrong ^{^[54]}

Thomas J opined that the efficient capital markets hypothesis no longer holds good:

[a]s it turns out, even ‘well-developed’ markets (like the New York Stock Exchange) do not uniformly incorporate information into market prices with high speed. [F]riction in accessing public information and the presence of processing costs means that not all public information will be impounded in a security’s price with the same alacrity, or perhaps with any quickness at all. ^{^[55]}

Empirical evidence, he said, supported the view that even when public information was incorporated into the market, it oftentimes was not done so accurately with the result that share price movements seemed unrelated to such information, or indeed occurred in the absence of any information. ^{^[56]}

Thomas J considered that the Basic Court’s assumption that investors trade on a belief in the integrity of the market price of shares was contradicted by the realitiesâsome investors trade because they believe the market has over or under valued the share price and they can use this mis-pricing to their advantage; some trade to meet changed liquidity needs; for tax reasons; or to re-balance their portfolios. ^{^[57]} Thus, it cannot be said that all investors rely on price integrity. Basic, however, asserted that it was sufficient that most investors rely on market price integrity, an assumption said Thomas J, that rested on nothing more than a ‘judicial hunch’ as evidence of such a fact. ^{^[58]} It was said in Basic that even those investors who trade because of a belief that the market is mis-priced are not indifferent to the integrity of the market price because they implicitly believe the share price will eventually reflect all material information. Thomas J said:

Whether the majority’s unsupported claims about the thought processes of hypothetical investors are accurate or not, they are surely beside the point. Whatever else an investor believes about the market, he simply does not ‘rely on the integrity of the market price’ if he does not believe that the market price accurately reflects public information at the time he transacts. That is, an investor cannot claim that a public misstatement induced his transaction by distorting the market price if he did not buy at that price while believing that it accurately incorporated that public information. For that sort of investor, Basic’s critical fiction falls apart. ^{^[59]}

Basic permits evidence to be adduced at the certification stage that an individual investor did not buy or sell shares in reliance on the integrity of the market price. Thus, said Thomas J:

Basic entitles defendants to ask each class member whether he traded in reliance on the integrity of the market price. That inquiry, like the traditional reliance inquiry, is inherently individualized; questions about the trading strategies of individual investors will not generate ‘common answers apt to drive the resolution of the litigation,’ … (Basic’s recognition that defendants could rebut the presumption ‘by proof the investor would have traded anyway appears to require individual inquiries into reliance’). ^[60]